A refresher for tax season on the some of the intricacies of claiming rental real estate income and losses

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  1. Passive activity limits. Generally, rental real estate activities are considered passive activities and losses are not deductible unless you have income from other passive activities to offset them.
  2. If there is active participation in a passive rental real estate activity, a loss of up to $25,000 of loss from the activity is allowed. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.
  3. Active participation is achieved by owning at least 10% of the rental property and making management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Examples of management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.
  4. There are income limitations on this allowed loss. Once a taxpayer’s modified adjusted gross income exceeds $100,000 the $25,000 loss is phased out. When modified adjusted gross income reaches $150,000 no loss is allowed. For MFS returns this limit is cut in half except when the spouses lived together (in this case there is no special loss allowed). This $100,000 threshold is not adjusted for inflation and has remained the same since the Tax Reform Act of 1986 was passed. Modified adjusted gross income is AGI without taking into account taxable social security, the deductions allowed for (IRAs, portion of SE tax, interest paid on student loans, qualified tuition and domestic production activities), passive activity gains or losses, losses from both real estate professionals and publicly traded partnerships and a few other exceptions. This convoluted calculation is what tax software programs are for.
  5. Rental real estate losses are allowed like other passive losses to the extent of gains from passive activities. When a rental property is sold all previously unallowed losses are allowed. Plus the excess of the gain over previously unallowed losses is used to allow any other passive losses. This can offer an incentive to taxpayers with large unallowed passive losses to sell appreciated rental property.
  6. If someone qualifies as a rental real estate professional all rental losses are allowed provided they also materially participate in the particular activity. In order to qualify for this exception the following conditions must be met. First more than half of the personal services the taxpayer performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated. This requirement makes it very difficult for anyone with full time employment to qualify. There have been several tax court cases almost all ruling against the taxpayer. Second the taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated.
  7. In order to meet the requirements of a real estate professional rental properties can be elected to be treated as a group. This election must be made or the IRS will view the properties as separate. According to the IRS instructions a written statement with the original income tax return for the first tax year in which two or more activities are originally grouped into a single activity. The statement must provide the names, addresses, and employer identification numbers (EIN), if applicable, for the activities being grouped as a single activity. In addition, the statement must contain a declaration that the grouped activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. In spite of these instructions the IRS has issued Rev Procedure 2011-34 which provides guidance to taxpayers on making a late election.
  8. There are downsides to making this election and the taxpayer will be bound by it once made. One downside is any suspended losses held from prior to making this election will not be freed up unless a complete disposition is made of all properties under the election. If any properties  can be expected to generate income the election should be made with care because that income will not be allowed to offset passive activities.
  9. The IRS has stepped up audits of real estate losses. According to a study by the GAO at least 53 percent of individual taxpayers with rental real estate activity for the tax year 2001 misreported the rental real estate activity, resulting in an estimated $12.4 billion of net misreported income.

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